In my attempts to engage in angel financing, I have seen the typical concerns that potential angel investors have. Many of these have to do with the investment parameters, and figuring out how investors can get their money back (or returns) – especially given the inherent immaturity of these businesses in being able to outline an exit potential. Investment then gets limited to businesses where investors perceive a high probability of creating a breakout business. Many other diamonds remain in the rough. I have been thinking of ways of addressing this issue so that seed financing is available to a larger base of startups. This should allow for great businesses to “emerge” rather than being “envisioned”.
To start, I am sharing some thoughts on a potential investment structure that should allow this to happen. There are several other elements to making this successful, besides the investment structure, and I will talk about some of those over next few weeks. In the meanwhile, comments and critiques are welcome on this – both from entrepreneurs and angel investors!
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If the accent of this post is on finding `diamonds in the rough’ and to help them `emerge’ as you rightly put, then is financing structure the point to start it off? Hasn’t this wrong sequence (coupled with ready open wallets, however few) been the principal reason why startup ecosystem got morphed into lifestyle business petri-dish for easy going funkies?
I think Post #1 will have to be on how to get angels, entrepreneurs and experienced executives together on a few executable ideas – in a more immersive way – than the event style carnivals that have clearly proved worthless banter and business card exchange forums. That initiative by itself will be a magnet for potential investors and entrepreneurs can focus on business building than on financial structures that will anyway happen only if it is mutually acceptable.
Alok good to see your thoughts on making seed funding more accessible to startups.
Making the investment more like debt is good for startups who can focus on getting cash flow in a year time. However, I doubt 2% monthly compounded rate of return would work. What credit card is to US startups; Friends, Family and Relatives is to Indian startups that is available at much cheaper rate.
To me for all kinds of startups here in India, a simple convertible debt would be a good start. 10% interest per year and discount in the range of 10% – 30% on next round of financing depending on risk involved (if opted to convert) looks good enough.
Another point I want to raise is more than financing, I see the problem of right angel with expertise been available for startups in India is a problem.
Deepak – thanks for the thoughts. Some followups:
1. I dont think the issue today is ability to set a valuation – I think the issue is that startups take forever to scale up, and many times may become lifestyle businesses. Thats where the debt structure helps.
2. Note that these are not convertibles – those get into the kind of issues you have mentioned.
3. 27% rate is great, but if one in two/three fail, effective yield is much lower. 27% in absolute terms is lower than credit card rate, which seems to be an acceptable startup financing vehicle in US 🙂
4. Bank debt can be senior to this debt, but the investor might need a protective covenant to require approval for such debt.
Like it. Best of both worlds for the investor – gets full debt protection and gets equity prerogative.
It can work really well with say a slight premium on the equity portion to account for extra money earned through the interest portion of the debt.
Valuation is still an issue though – if you could value properly then why bother with debt, as unsecured debt isn’t all that safe a deal at startup levels. Maybe put a blanket figure like 4 cr. as the floor, with the floor being revised (upwards) to say a 10% discount to latest round of funding if achieved prior to conversion. (Can look at no shareholder protection allowed to debt holders/warrant holders to deny such funding – otherwise the incentives are all screwed up)
There are some legalities about warrants needing some minimum portion paid up (lost on non-conversion), IIRC. There’s also a debenture route but I think the regulators want either compulsorily convertible or totally non convertible ones, so the “option” bits are out of the game. Maybe CA/Company Secretary folks on the list can confirm.
I think Goldman had exactly such a deal with Buffett and since then a number of such deals have happened.
BTW, monthly compounded 2% is 27% simple on the year; a mighty good return if you can get it. But like you said, actual numbers will be malleable.
Some issues I can think of:
1) Company will find it difficult to get working capital/other loans from banks etc. until the debt is cleared off the books. Not of concern to most tech startups, but a slight pain when you have to deal with letters of credit etc. with a different kind of export business (for example)
2) Example of interest will actually end up like this: 10L at 2% monthly compounding = 12.68L after a year. That is the new principal after 1 year. So monthly payment required will be 25K interest, and 5K principal repayment. (Co will take 8 years to repay at that rate, but yeah, business should accelerate – or the company an refinance from a debt-only source if it’s available). Most angels though would struggle to get more than 1% a month (compounded monthly) on their money so that might be a more usable figure. (Just thinkin)
Alok: My (kneejerk) reaction: No seed/early-stage start-up should take debt (friends and fmaily excluded)…
Admittedly this is a “kneejerk reaction”…hope this gets the ball rolling on comments!